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Financial Management: Principles and Applications, 11e (Titman)

Chapter 18 Working Capital Management


18.1 Working Capital Management and the Risk-Return Tradeoff
1) An increase in ________ would increase net working capital.
A) plant and equipment
B) accounts payable
C) accounts receivable
D) both B and C
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) P. Noel's Inc.'s current ratio is 2. Current liabilities are $500,000. P. Noel's current assets equal
________ and net working capital is ________.
A) $500,000 and $1,000,000
B) $500,000 and $250,000
C) $1,000,000 and $500,000
D) $500,000 and $500,000
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Total assets must equal the sum of which sources of financing?
A) Spontaneous
B) Temporary
C) Permanent
D) Spontaneous, temporary and permanent
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff

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4) Which of the following could offset the higher risk exposure a company would face if it s
current ratio and net working capital were relatively low.?
A) Its current assets would need to be highly liquid.
B) Its accounts receivable collection policy could increase the average collection period.
C) It could offer no discounts for early payment by its customers.
D) It could buy back some of its shares in the open market in order to reduce its equity.
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Which of the following would be considered an issue that is related to the management of
working capital?
A) How much inventory should the firm maintain?
B) How should a firm finance its current assets?
C) To whom should the firm grant trade credit?
D) All of the above
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) An increase in ________ would increase a firm's liquidity.
A) notes payable
B) inventories
C) cash
D) both B and C
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) A decrease in ________ would increase net working capital.
A) accounts payable
B) accounts receivable
C) cash
D) equipment
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff

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8) In general, the greater a firm's reliance upon short-term debt or current liabilities, the lower
the:
A) liquidity.
B) flexibility.
C) certainty of interest costs.
D) both A and C.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) The risk of a firm not being able to pay its bills on time is called:
A) illiquidity.
B) insolvency.
C) capital inadequacy.
D) float.
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) Which of the following will reduce the liquidity of a firm? An increase in:
A) short-term notes payable.
B) accounts payable.
C) current assets.
D) both A and B.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) Within the context of working capital management:
A) as the firm increases its investment in working capital, there is a corresponding increase in its
profits.
B) current liabilities provide a flexible means of financing the firm's fluctuating needs for assets.
C) the use of current liabilities or short-term debt as opposed to long-term debt subjects the firm
to less risk of illiquidity.
D) all of the above.
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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12) Net working capital refers to which of the following?


A) Current assets
B) Current assets minus current liabilities
C) Current assets minus inventory
D) Current assets divided by current liabilities
E) Current assets minus inventory divided by current liabilities
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Which of the following is most likely to occur if a firm over-invests in net working capital?
A) The current ratio will be lower than it should be.
B) The quick ratio will be lower than it should be.
C) The return on investment will be lower than it should be.
D) The times interest earned ratio will be lower than it should be.
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) Which of the following is most likely to occur if a firm under-invests in net working capital?
A) The firm might not have sufficient cash to pay its bill in a timely manner.
B) The firm might not have adequate inventory to meet the needs of its customers.
C) The firm could be losing sales because its terms of sale are too strict.
D) All of the above.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
15) Solstice Corporation has current assets of $10 million and current liabilities of $8 million.
Solstice's current ratio is ________ and its net working capital is ________.
A) 1.25, $10 million
B) 1.25, $2 million
C) 2, $1.25 million
D) .8, ($2 million)
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff

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16) J.B. 's Wholesale Club has current assets of $12.25 million and current liabilities of $14
million. Which of the following is possible.
A) J.B. makes efficient use of its current assets.
B) J.B. may be at some risk of being unable to pay its bills.
C) J.B. appears to be overinvesting in current assets.
D) Either or both A and B may be true.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) Working capital refers to investment in current assets, while net working capital is the
difference between current assets and current liabilities.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) Net working capital provides a very useful summary measure of a firm's short-term financing
decisions.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Within the context of working capital management, the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) Managing a firm's liquidity is basically the same as managing a firm's net working capital.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff

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21) The balance sheet for Peterson Manufacturing Company is presented below.
Peterson Mfg. Co.
Balance Sheet
December 31, 1995
Cash
$32,000 Current liabilities
$72,000
Accounts receivable 40,000 Long-term liabilities 48,000
Inventories
48,000 Common equity
120,000
Total current assets$120,000
Net fixed assets
120,000
Total
$240,000 Total
$240,000
During 2009, the firm earned $28,000 after taxes based on net sales of $480,000.
a. Calculate Peterson's current ratio and net working capital.
b. Assume that Peterson's uses $20,000 of its cash to reduce current liabilities. Recompute the
current ratio and net working capital.
c. What effect, if any, does the change proposed in question b have on Peterson's liquidity.
Answer:
a. Current ratio = ($120,000)/($72,000) = 1.67
Net working capital = $120,000 - $72,000 = $48,000
b. Current ratio = ($100,000)/($52,000) = 1.92
Net working capital = $100,000 - $52,000 = $48,000
c. Yes, the firm's liquidity position as measured by the current ratio improves slightly but the
amount of net working capital is less. The composition of Peterson's current assets is less liquid
than before because cash is the most liquid asset.
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff

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22) The December 31, 1995 balance sheet for Spitco, Inc. is presented below.
Spitco, Inc.
Balance Sheet
December 31, 2010
Current assets
$40,000
Net fixed assets
20,000
Total
$60,000
Accounts payable
11,000
Notes payable
12,000
Total
$23,000
Long-term debt (10%)
12,000
Common equity
25,000
Total
$60,000
a. Calculate Spitco's current ratio, and net working capital.
b. Spitco feels that its current ratio is too far below the industry average of 2.40. To improve their
liquidity, the treasurer of Spitco has devised a plan to issue $12,000 in long-term debt at 12% and
pay off its notes payable. The funds would be invested in marketable securities at 7% interest
when not needed to finance the firm's seasonal asset needs. The notes payable would remain
outstanding through the year. Assume this plan had been implemented for 2010. Calculate what
the firm's current ratio, and net working capital would have been.
c. Did Spitco improve their liquidity? What do you think happened to Spitco's return on
investment?
Answer:
a. Current ratio = (current assets)/(current liabilities) = ($40,000)/($23,000) = 1.74x
Net working capital = current assets - current liabilities = $40,000 - $23,000 = $17,000
b. Current ratio = ($40,000)/($11,000) = 3.64x
Net working capital = $40,000 - $11,000 = $29,000
c. Yes, liquidity is now well above the industry average. The firm's return on investment has
probably fallen.
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff

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23) On June 30, 19X1, the Alexander Bosh Coffee Co.'s balance sheet and income statement are
as follows:
Balance Sheet
Income Statement
June 30, 19X1
June 30, 19X1
Current assets
$800,000
Net operating income$600,000
Net fixed assets
700,000
Less: interest expense(108,000)
Total assets
$1,500,000
Earnings before taxes492,000
Accounts payable
$300,000
Less: taxes (34%) (167,280)
S-T notes payable (15%) 500,000
Net income
$324,720
Total current liabilities $800,000
Long-term debt (11%) $300,000
Common equity
400,000
Total
$1,500,000
a.
Calculate the current ratio and net working capital for Alexander Bosh.
b.
Recalculate the ratios from (a) and assess the change in the firm's liquidity if the firm
plans to issue $500,000 in common stock and use the proceeds to retire the firm's notes payable.
c.
What effect would the change proposed in question b have on return on common equity
(net income/common equity)?
Answer: a. Current ratio = $800,000/$800,000 = 1.0
Net working capital = $800,000 - $800,000 = 0.0
b.
Current ratio = $800,000/$300,000 = 2.667
Net working capital = $800,000 - $300,000 = $500,000
c.
Alexander Bosh's net income would not change, but equity would increase by $500,000,
so return on equity would fall from $324,720/$400,000 = 81% to $324,720/($400,000 +
$500,000) = 36%
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
18.2 Working Capital Policy
1) Accounts payable is considered a:
A) spontaneous liability.
B) temporary financing source.
C) permanent financing source.
D) both A and B.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff

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2) Which of the following is NOT considered a permanent source of financing?


A) Corporate bonds
B) Common stock
C) Preferred stock
D) Commercial paper
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Which of the following is most likely to be a temporary source of financing?
A) Commercial paper
B) Preferred stock
C) Long-term debt
D) All of the above
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
4) What is the conventional method for financing permanent levels of accounts receivable and
inventory?
A) Bonds and equity
B) Short-term loans
C) Accounts payable and accrued expenses
D) Equity only
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent investments
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Commercial paper:
A) rates are generally higher than rates on bank loans and comparable sources of short-term
financing.
B) generally has a minimum compensating balance requirement.
C) offers the firm with very large credit needs a single source for all its short-term financing.
D) has all of the properties stated above.
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff

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6) Gamma, Inc. plans to sell $1 million in 270-day-maturity commercial paper on which it will
pay discounted interest at an annual rate of 12%. In addition, Gamma expects to incur a cost of
$1,000 in dealer placement fees and other expenses to issue the paper. What is the effective cost
of the paper to Gamma?
A) 12.22%
B) 12.78%
C) 13.20%
D) 13.35%
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) With respect to working capital policy, firms most often employ:
A) a cautious approach which finances short-term assets with long-term financing.
B) the principle of self-liquidating debt.
C) an aggressive approach which finances long-term assets with short-term financing.
D) the principle of liquidity optimization.
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) A toy manufacturer following the self-liquidating debt. principle will generally finance
seasonal inventory build-up prior to the Christmas season with:
A) common stock.
B) selling equipment.
C) trade credit.
D) preferred stock.
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
9) Which of the following is considered to be a spontaneous source of financing?
A) Operating leases
B) Accounts receivable
C) Inventory
D) Accounts payable
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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10) Current assets of NorthPole.com at the end of each quarter were: 1st quarter $1.3 million,
2nd quarter $1.7 million, 3rd quarter $1.5 million and 4th quarter $2.2 million. The best estimate
for North Pole's permanent current assets is:
A) $2.2 million.
B) $1.675 million.
C) $1.3 million.
D) $0.9 million.
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent investments
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) Disadvantages of using current liabilities as opposed to long-term debt include:
A) greater risk of illiquidity.
B) uncertainty of interest costs.
C) higher cash flow exposure.
D) both A and B.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) According to the self-liquidating debt principle permanent assets should be financed with
________ liabilities.
A) permanent
B) spontaneous
C) current
D) fixed
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Which of the following is most consistent with the self-liquidating debt principle in working
capital management?
A) Fixed assets should be financed with short-term notes payable.
B) Inventory should be financed with preferred stock.
C) Accounts receivable should be financed with short-term lines of credit.
D) Borrow on a floating rate basis to finance investments in permanent assets.
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
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14) With regard to the self-liquidating debt, which of the following assets should be financed
with permanent sources of financing?
A) Machinery
B) Expansion of inventory to meet seasonal demands
C) Machinery and expansion of inventory to meet seasonal demands
D) Minimum level of accounts receivable required year round, machinery, and minimum level of
cash required for year-round operations
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
15) Spontaneous sources of financing include:
A) marketable securities.
B) accruals.
C) bonds.
D) commercial paper.
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) Which of the following is NOT a spontaneous source of financing?
A) Accrued salaries payable
B) Loans secured by accounts receivable
C) Accrued taxes payable
D) Accounts payable
Answer: B
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) A quite risky working capital management policy would have a high ratio of:
A) short-term debt to bonds and equity.
B) short-term debt to total debt.
C) bonds to property, plant, and equipment.
D) short-term debt to equity.
Answer: A
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff

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18) Which of the following is a spontaneous source of financing?


A) Accrued wages
B) Preferred stock
C) Trade credit
D) Both A and C
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Trade credit is an example of which of the following sources of financing?
A) Spontaneous
B) Temporary
C) Permanent
D) Both A and B
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) If management expects interest rates to rise and credit to tighten in the near future, it should
consider:
A) increasing its use of commercial paper and loans secured by current assets.
B) decreasing the use of spontaneous financing.
C) decreasing the level of permanent financing.
D) increasing the level of permanent financing.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
21) All else equal, which of the following is the most likely to occur if actual sales are much less
than forecasted sales?
A) The company will be in a better position to pay down most of its debt.
B) The firm's actual investment in inventory will be unchanged from the amount forecasted.
C) Accounts receivable will rise significantly above the forecast.
D) The company might face a cash flow crunch.
Answer: D
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff

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22) Which of the following types of financing offers the firm the greatest degree of flexibility?
A) Bonds
B) Preferred stock
C) Short-term lines of credit
D) Long-term notes payable
Answer: C
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
23) The use of short-term debt provides flexibility in financing since the firm is only paying
interest when it is actually using the borrowed funds.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
24) Issuers of commercial paper usually maintain lines of credit with banks to back up their
short-term financing needs.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
25) Within the context of working capital management, the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
26) Accrued wages are considered an unsecured, non-spontaneous source of financing.
Answer: FALSE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff

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27) The primary sources of collateral for short-term secured loans are accounts receivable and
inventory.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
28) Trade credit appears on a company's balance sheet as accounts payable.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
29) A firm can reduce net working capital by substituting long-term financing, such as bonds,
with short-term financing, such as a one-year notes payable.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
30) Increasing the use of short-term debt versus long-term debt financing will increase profit.
Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
31) Notes payable is a spontaneous source of financing.
Answer: FALSE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
32) Short-term debt is frequently less expensive because it provides the borrower more security.
Answer: FALSE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff

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33) Trade credit is a source of spontaneous financing.


Answer: TRUE
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
34) Summary data from the quarterly balance sheets of ACH Air Conditioners are shown below.
Quarter 1
Quarter 2
Quarter 3
Quarter 4
Current Assets
$50,000
$90,000
$75,000
$30,000
Fixed Assets
$60,000
$60,000
$60,000
$60,000
Liabilities
$70,000
$110,00
$95,000
$50,000
Equity
$40,000
$40,000
$40,000
$40,000
.
a. If ACH follows the self liquidating debt principle, how much long-term debt will be used to
finance current assets? Explain your answer briefly.
b. What would be the highest and lowest levels of temporary debt?
Answer: a. It would appear from the quarterly balance sheets that current assets do not fall
below $30,000, so that part of the current assets should be financed with long-term funds.
b. Temporary debt should peak at ($90,000 - $30,000) = $60,000 in the 2nd quarter. At the end of
the fourth quarter, ACH should have no temporary debt.
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent investments
Principles: Principle 2: There Is a Risk-Return Tradeoff
35) L. Stevens Inc. uses long-term to cover its peak level of current assets. When it does not need
the money to finance inventories and accounts receivable, it invests the excess funds in shortterm certificates of deposit. What are the advantages and disadvantages of this policy?
Answer: By financing all of its temporary needs with long-term funds, L. Stevens avoids the
inconvenience of arranging for short-term loans on a frequent basis. The company also insulates
itself from the risks of rising interest rates and tight credit. On the other hand, interest on longterm debt is usually higher than on short-term debt and L. Stevens will have to pay interest on
the full year rather than just for the period when it needs the funds. It is very unlikely that the
rate earned on short-term investments will equal the rate paid on the long-term debt, so this
policy will reduce the company's profits.
Diff: 2
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff

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18.3 Operating and Cash Conversion Cycles


1) King Co.'s inventory turnover ratio is 12. It's inventory conversion period is:
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.
Answer: B
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: inventory conversion period
Principles: Principle 3: Cash Flows Are the Source of Value
2) Prince Co.'s inventory turnover ratio is 30.4. It's inventory conversion period is:
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.
Answer: A
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: inventory conversion period
Principles: Principle 3: Cash Flows Are the Source of Value
3) Queen Co.'s balance in accounts receivable is $240,000. Annual credit sales are $2,880,000.
Queen's average collection period is:
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.
Answer: B
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: average collection period
Principles: Principle 3: Cash Flows Are the Source of Value
4) Frosty's Frozen Food Inc.'s inventory balance is $1.22 million. Frosty's Cost of Good's Sold is
$30.4 million. It's inventory conversion period:
A) 12 days.
B) 24.92 days.
C) 14.65 days.
D) 299.2 days.
Answer: C
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: inventory conversion period
Principles: Principle 3: Cash Flows Are the Source of Value
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5) Currier & Ive's Lithography has a Cost of Goods Sold of $60.8 million. The company's
accounts payable balance is $7.5 million. It's accounts payable deferral period is:
A) 81 days.
B) 45 days.
C) 8.11 days.
D) 48.7 days.
Answer: B
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: accounts payable deferral period
Principles: Principle 3: Cash Flows Are the Source of Value
6) Abbot Corporation has an average collection period of 49 days, an inventory conversion
period of 83 days, and a payables deferrable period of 36 days. What is Abbott's cash conversion
cycle?
A) 96 days
B) 70 days
C) 85 days
D) 132 days
Answer: A
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
7) Abbot Corporation has an average collection period of 49 days, an inventory conversion
period of 83 days, and a payables deferrable period of 36 days. What is Abbott's operating cycle?
A) 96 days
B) 70 days
C) 85 days
D) 132 days
Answer: D
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: operating cycle
Principles: Principle 3: Cash Flows Are the Source of Value
8) Clark Corporation has an average collection period of 7 days, an inventory conversion period
of 30 days, and a payables deferrable period of 60 days. What is Clark's operating cycle?
A) 97 days
B) 37 days
C) 23 days
D) -23 days
Answer: B
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: operating cycle
Principles: Principle 3: Cash Flows Are the Source of Value
18
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9) Clark Corporation has an average collection period of 7 days, an inventory conversion period
of 30 days, and a payables deferrable period of 60 days. What is Clark's cash conversion cycle?
A) 97 days
B) 37 days
C) 23 days
D) -23 days
Answer: D
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
10) Becker.com has an inventory turnover ratio of 52, an accounts receivable balance of
$365,000, average daily credit sales of $36,500, accounts payable of $182,500 and cost of goods
sold of $7,993,500. What is Becker's operating cycle to the nearest day?
A) 17 days
B) 61 days
C) 27 days
D) -27 days
Answer: A
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: operating cycle
Principles: Principle 3: Cash Flows Are the Source of Value
11) Becker.com has an inventory turnover ratio of 52, an accounts receivable balance of
$365,000, average daily credit sales of $36,500, accounts payable of $182,500 and cost of goods
sold of $7,993,500. What is Becker's cash conversion cycle to the nearest day?
A) 17 days
B) 61 days
C) 27 days
D) -27 days
Answer: D
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
12) ViteS Equipment Company has increased its inventory turnover ratio from 12 to 18. By how
many days has it reduced the operating cycle?
A) 20 days
B) 6 days
C) 10 days
D) 1.5 days
Answer: C
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: operating cycle
19
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Principles: Principle 3: Cash Flows Are the Source of Value


13) It is not possible to have a negative cash conversion cycle.
Answer: FALSE
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
14) The operating cycle can never be longer than the cash conversion cycle.
Answer: FALSE
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
15) As the inventory turnover ratio decreases, the inventory conversion cycle increases.
Answer: TRUE
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: inventory conversion period
Principles: Principle 3: Cash Flows Are the Source of Value
16) Increasing the accounts payable deferral period also increases the cash conversion cycle.
Answer: FALSE
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value
17) A& B Global's annual credit sales are $18 million; the accounts receivable balance is $1.5
million; the cost of goods sold is $12.6 million; the inventory balance is $350,000, and the
balance in accounts payable is $700,000.
a. Compute A&B's operating cycle.
b. Compute A&B's cash conversion cycle.
Answer: Average collection period = $1,500,00/($18,000,000/365) = 30.42 days. Inventory
conversion period = $350,000/($12,600,000/365) = 10.14 days. The accounts payable deferral
period is 365/($12,600,000/$700,000 ) = 20.28 days.
a. Operating cycle = 30.42+10.14 = 40.56 days.
b. Cash conversion cycle = 40.56 - 20.28 = 20.28 days.
Diff: 2
Topic: 18.3 Operating and Cash Conversion Cycles
Keywords: cash conversion cycle
Principles: Principle 3: Cash Flows Are the Source of Value

20
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18.4 Managing Current Liabilities


1) A firm buys on terms of 3/10, net 30. What is the cost of trade credit under these terms?
A) 55.7%
B) 47.4%
C) 31.5%
D) 23.2%
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
2) The correct equation for calculating the cost of short-term credit is:
A) rate = interest/(principal time).
B) rate = (principal time)/interest.
C) rate = principal/(time interest).
D) rate = principal interest time.
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
3) Which item would constitute poor collateral for an inventory loan?
A) Lumber
B) Vegetables
C) Copper
D) Chemicals
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: secured current liabilities
Principles: Principle 3: Cash Flows Are the Source of Value
4) Which of the following statements regarding a line of credit is true?
A) The purpose for which the money is being borrowed must be stated by the borrower.
B) A line of credit agreement usually fixes the interest rate that will be applied to any extensions
of credit.
C) A line of credit agreement is a legal commitment on the part of the bank to provide the stated
credit.
D) Such agreements usually cover the borrower's fiscal year.
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
21
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5) Which of the following is an advantage of using commercial paper for short-term credit?
A) The ability of some firms to obtain large amounts of credit
B) A readily available source of credit for most firms
C) It is a type of free credit
D) It can be issued for very small amounts
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
6) The First Webster Bank requires borrowers to maintain a balance of 10% of the line of credit
in a non-interest paying account as compensation for providing the line of credit. If the borrower
would not normally have deposits in such an account, the APR will be:
A) the amount borrowed will be higher than the amount needed.
B) the APR will be less than the stated rate.
C) the amount borrowed will be lower than the amount needed.
D) neither the amount borrowed nor the APR will be affected by the required balance.
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
7) A company which foregoes the discount when credit terms are 4/15 net 70 is essentially
borrowing money from his supplier for an additional:
A) 40 days.
B) 55 days.
C) 70 days.
D) 85 days.
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
8) A company that foregoes a discount of 1/7 net 30 is essentially borrowing money from the
vendor at:
A) 1%.
B) 12.29%.
C) 16%.
D) 52.7%.
Answer: C
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
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9) What factors should we consider when selecting a source of short-term credit?


A) Effective cost and availability
B) Liquidity and profitability
C) Historical trend analysis and liquidity
D) None of the above
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
10) Once a cash discount period has passed:
A) one should pay immediately.
B) there is no financial incentive to pay before the final due date.
C) one should pay after the final due date.
D) cannot be determined from the information.
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
11) Bank Two extends a $3 million line of credit to Capital Corp. The stated rate of interest is
9.5%. Bank Two requires Capital to maintain compensating balances equal to 10% of the amount
of the line. Assuming that Capital would not normally carry any deposits at the bank, what is the
effective annual rate of interest on the loan?
A) 9.5%
B) 10.6%
C) 11.6%
D) 12.3%
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
12) The Stant Shoe Company established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $100,000 at an annual rate of
5%. A compensating balance of 10% of the amount borrowed is required. What is the largest
amount of money Stant will actually be able to use from the line of credit?
A) $90,909
B) $90,000
C) $111,111
D) $100,000
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
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Principles: Principle 3: Cash Flows Are the Source of Value


13) Smith Enterprises has a line of credit with Fidelity National Bank that allows Smith to
borrow up to $350,000 at an interest rate of 5%. However, Smith must keep a compensating
balance of 10% of any amount borrowed on deposit at Fidelity. Smith does not normally keep a
cash balance account with Fidelity. What is the effective annual cost of credit (round to nearest .
01 percent)?
A) 5.93%
B) 5.84%
C) 5.64%
D) 5.56%
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
14) Georgia Peaches Corporation (GPC) has a line of credit with Trust Company Bank that
allows GPC to borrow up to $300,000 at an annual interest rate of 5.5%. However, GPC must
keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company
Bank. GPC does not normally have a cash balance account with the Trust Company. What is the
effective annual cost of credit?
A) 6.875%
B) 6.975%
C) 7.075%
D) 7.775%
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
15) Which of the following comparisons between short-term bank loans is correct?
A) Commercial paper interest rates are usually slightly higher than rates on bank loans.
B) Commercial paper is only appropriate for firms requiring a limited amount of short-term
financing, while banks can offer substantially larger amounts of funds.
C) Banks demand that borrowers meet exacting credit-worthiness tests, while the lenders that
purchase commercial paper are less strict. Only the most credit-worthy borrowers have access to
bank loans.
D) None of the above.
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: temporary sources of financing
Principles: Principle 3: Cash Flows Are the Source of Value

24
Copyright 2011 Pearson Education, Inc.

16) The Stoney River Textiles Company will borrow $50 million for 180 days from Merrimac
Bank. The bank will charge Stoney River 4.5 % on a discounted basis. What is the annual
percentage rate (APR) to Stoney River (round to the nearest .1 percent)?
A) 2.25%
B) 2.36%
C) 4.71%
D) 4.5%
Answer: C
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
17) The Stoney River Textiles Company will borrow $50 million for 180 days from Merrimac
Bank. The bank will charge Stoney River 4.5 % on a discounted basis. What is the dollar amount
of interest Stoney River will need to pay? Assume a 360 day year.
A) $1,125,000
B) $1,099,688
C) $2,250,000
D) 41,074,375
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
18) The annual cost of not taking advantage of the 3/10, net 30 terms offered by a supplier is
(hint: use $1.00 as the invoice amount and a 360-day year):
A) 55.7%.
B) 45.4%.
C) 32.3%.
D) 28.2%.
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value

25
Copyright 2011 Pearson Education, Inc.

19) Atlas Tire Irons, Inc. is considering borrowing $5,000 for a 3 month period. The firm will
repay the $5,000 principal amount plus $150 in interest. What is the annual percentage rate
(APR) rate of interest (use a 360-day year)?
A) 3%
B) 12%
C) 15%
D) 18%
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
20) Which of the following would NOT be considered an unsecured loan?
A) Accrued tax payments
B) Line of credit
C) Transaction loans
D) Factored accounts receivable
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: factoring
Principles: Principle 3: Cash Flows Are the Source of Value
21) The primary advantage that factoring accounts receivable provides is:
A) the flexibility it gives to the borrower.
B) that the financial institution bears the risk of collection.
C) the low cost as compared with other sources of short-term financing.
D) that the financial institution services the accounts.
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: factoring
Principles: Principle 3: Cash Flows Are the Source of Value
22) The Omega Corp. plans to borrow $10,000 for a 2 months. At maturity, Omega will repay the
$10,000 principal plus $100 interest. What is the annual percentage rate (APR) rate of interest on
this loan?
A) 6%
B) 1%
C) 4%
D) 6.4%
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
26
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23) The cost of trade credit varies with the:


A) size of the cash discount.
B) length of time between the end of the discount period and the final due date.
C) length of time between the end of the discount period and when the firm purchased from the
supplier.
D) both A and C.
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
24) Which of the following is an advantage of trade credit?
A) Trade credit is conveniently obtained as a normal part of the firm's operations.
B) No formal agreements are generally involved in extending credit.
C) The amount of credit extended expands and contracts with the needs of the firm.
D) All of the above.
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
Quick Corp. makes its purchases under terms of 2/10 net 30.
25) If Quick Corp. foregoes the discount and pays for its purchases according to the terms of its
trade credit, what is Quick's effective cost of using this source of credit?
A) 26.67%
B) 31.48%
C) 36.73%
D) 51.32%
Answer: C
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value

27
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26) If Quick foregoes the discount but does not pay for its purchases until day 40, what is
Quick's effective cost of using this source of credit? Assume that no penalty is incurred for late
payment.
A) 38.37%
B) 36.73%
C) 26.67%
D) 24.49%
Answer: D
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
27) When a commercial bank extends short-term credit to a firm, it can provide a line of credit
that involves:
A) a legal obligation on the part of the bank to provide the stated credit.
B) no legal obligation on the part of the bank to provide the stated credit.
C) the requirement that the borrower maintain a compensating balance with the bank throughout
the loan period.
D) a fixed rate of interest.
Answer: C
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
Use the following information to answer the following question(s).
ABC, Inc. requires $270,000 in short-term credit and is currently arranging a loan with its bank.
ABC plans to use the funds for six months, the annual rate on the loan is 12%, and the bank will
require a 10% compensating balance.
28) If ABC must have loan proceeds of $270,000, then it must borrow:
A) $270,000.
B) $300,000.
C) $410,000.
D) $500,000.
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value

28
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29) What is the annual percentage cost of the loan?


A) 15.67%
B) 14.00%
C) 13.33%
D) .83%
Answer: C
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
30) A firm will borrow $1 million for six months on a discount basis. The annual interest rate on
the loan is 12%. What is the annual percentage cost of the loan?
A) 11.00%
B) 12.77%
C) 13.00%
D) 14.23%
Answer: B
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
31) Pledging accounts receivable as a source of short-term credit:
A) is a type of loan secured by accounts receivable.
B) is a form of spontaneous credit.
C) involves the outright sale of accounts receivable to a financial institution.
D) is an inexpensive but risky source of short-term financing.
Answer: A
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: secured current liabilities
Principles: Principle 3: Cash Flows Are the Source of Value
32) The effective cost to the borrower of an unsecured bank loan is increased if a compensating
balance is required.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
33) Commercial paper is a source of credit available to large firms with healthy balance sheets.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: commercial paper
Principles: Principle 3: Cash Flows Are the Source of Value
29
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34) A major risk in using commercial paper for short-term financing is the inflexible repayment
schedule.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: commercial paper
Principles: Principle 3: Cash Flows Are the Source of Value
35) Prior to establishing trade credit, the firm is required to make extended formal agreements
with the company.
Answer: FALSE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
36) Lines of credit often require that the borrower maintain a minimum balance in the bank
throughout the loan period.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value
37) Trade credit provides one of the most flexible sources of short-term financing available to the
firm.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
38) Commercial paper is an unsecured form of credit.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: commercial paper
Principles: Principle 3: Cash Flows Are the Source of Value
39) Lines of credit involve fixed rates of interest.
Answer: FALSE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: line of credit
Principles: Principle 3: Cash Flows Are the Source of Value

30
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40) Secured loans are those that are secured by the lender's faith in the ability of the borrower to
repay the funds when due.
Answer: FALSE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: secured current liabilities
Principles: Principle 3: Cash Flows Are the Source of Value
41) Accrued wages and taxes provide sources of financing that rise and fall spontaneously with
the level of the firm's sales.
Answer: TRUE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: spontaneous sources of financing
Principles: Principle 3: Cash Flows Are the Source of Value
42) Commercial paper offers the borrower the same flexibility that exists when bank credit is
used to meet financing needs.
Answer: FALSE
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: commercial paper
Principles: Principle 3: Cash Flows Are the Source of Value
43) Describe the differences between secured and unsecured short-term credit.
Answer: Secured loans are backed by the pledge of specific assets. Examples of secured loans
include accounts receivable and inventory loans. Unsecured loans are only backed by the
promise of the borrower to honor the loan commitment. If loans are unsecured, and not paid, the
creditor would have to obtain a judgment then legally execute on assets of the borrower.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: secured current liabilities
Principles: Principle 3: Cash Flows Are the Source of Value
44) Discuss the advantages of using commercial paper.
Answer: There are four advantages of using commercial paper. First, commercial paper rates are
generally lower than rates on bank loans and comparable sources of short-term financing.
Second, commercial paper does not require a minimum balance. However, issuing firms usually
maintain lines of credit agreements to back their short-term financing needs just in case the issue
of commercial paper cannot be sold. Third, commercial paper offers the firm with very large
credit needs a single source for all its short-term financing. Fourth, the use of commercial paper
is a sign of prestige for the issuing company.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: commercial paper
Principles: Principle 3: Cash Flows Are the Source of Value
31
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45) Calculate the effective cost of the following trade credit terms if the discount is foregone and
payment is made on the net due date.
a. 2/15 net 30
b. 2/15 net 45
c. 2/15 net 60
Answer:
a. ($0.02/$0.98) [1/(15/360)] = .4898
b. ($0.02/$0.98) [1/(30/360)] = .2449
c. ($0.02/$0.98) [1/(45/360)] = .1633
The cost of foregoing trade credit decreases as the length of time between the end of the discount
period and the end of the net due period increases.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: trade credit
Principles: Principle 3: Cash Flows Are the Source of Value
46) The U.R. Bloom Corporation established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $125,000 at a rate of 5%. A
compensating balance averaging 10% of the loan is required. If the firm needs $100,000 for six
months, what is the dollar cost of the loan and the annual percentage rate (APR)?
Answer: Borrowed funds = ($100,000/0.9) = $111,111
Dollar cost = $111,111 .05/2 = $2,777.78
APR = .05/.9 = 5.56%
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
47) Maximus, Inc. is planning to borrow $2 million for 9 months at a discounted interest rate of
4.5%. What is the annual percentage rate on the loan?
Answer: Interest =$2,000,000 .045 9/12 = $67,500
Rate = 67,500/(2,000,000 - 67,500) 12/9 = 4.66%
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value

32
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48) The Smith Corporation has purchased $500,000 worth of inventory. The vendor offers terms
of 1/15 net 45. Unfortunately, Smith does not have enough cash available to take advantage of
the discount. It can borrow $500,000 from Wesson National Bank for 30 days at an annual
percentage rate of 6%. Should Smith forego the discount or pay within the discount period with
money borrowed from the bank?
Answer: In either case, Smith will effectively be borrowing the money for 30 days. The APR
implied by the discount is 1/99 365/30 = 12.29% so Smith should clearly borrow from the
bank.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
49) Lightbulbs.com sells industrial and institutional lighting supplies through its website. It sells
directly to businesses and organizations such as universities and hospitals on terms of net 90. To
finance its rather large investments in receivables and inventory, the firm has an average need for
$2,000,000 in short-term loans. It is choosing between 3 alternative arrangements:
Converse Bank offers a 4.75% APR with interest and principal paid at the end of the year.
Guaranty Bank offers a rate of 4.5% with interest discounted at the time of the loan.
County Bank offers 4.25% with a 10% compensating balance.
Which bank offers the APR when all terms of the loan are considered? You may assume that
required amounts are borrowed for the full year.
Answer: Converse Bank's rate is simply 4.75%.
Guaranty Bank's APR =.045(2,000,000)/(2,000,000 - 90,000) = .045/.955 = 4.71%
County Bank's APR = .0425/ .90 = 4.72%
There is very little real difference between the three banks but Guaranty offers the lowest APR
by a slight margin.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value
50) The annual percentage rate (APR) on short-term loans from Bank A is 5.75% per year. Bank
B claims that their interest rate is only 5.44% per year. However, Bank B charges interest on a
discount basis. Which bank is charging the lowest APR on a one-year loan?
Answer: APR from Bank A = 5.75%
APR from Bank B = 5.44/(1 - .0544) = 5.753
Bank A is charging the lowest rate of interest by a very small amount.
Diff: 2
Topic: 18.4 Managing Current Liabilities
Keywords: annual percentage rate
Principles: Principle 3: Cash Flows Are the Source of Value

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18.5 Managing the Firm's Investment in Current Assets


1) Which of the following is NOT a typical characteristic of money-market securities?
A) Little or no default risk
B) Liquid, easily bought and sold
C) Interest is not taxable at state or federal level
D) Maturities less than 1 year
Answer: C
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) A disadvantage involved in investing in marketable securities is that:
A) this reduces the risk of illiquidity.
B) this investment increases net working capital.
C) this investment offers a flexible means of financing.
D) these assets offer low rates of return, commensurate with their risk.
Answer: D
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) "Float" is the term given to:
A) differences between the cash balance and the balance of cash plus marketable securities.
B) differences between the cash balance in the ledger and the funds available in the firm's
checking account.
C) the period between the date an invoice is received and the date on which it must be paid.
D) the practice of deliberately delaying payments beyond the due date.
Answer: B
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
4) Typical securities in which firms invest their temporary cash surpluses include all of the
following EXCEPT:
A) U. S. Treasury Bills.
B) commercial paper.
C) high quality corporate bonds.
D) Money Market Mutual Funds.
Answer: C
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright 2011 Pearson Education, Inc.

5) Which of the following would NOT typically be used for assessing customer quality for
purposes of granting trade credit?
A) Ratio analysis
B) Aging of accounts receivable
C) Credit scoring
D) Credit rating services
Answer: B
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: accounts receivable
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Accounts receivable typically comprise ________ of a firm's assets.
A) 25%
B) 50%
C) less than 1%
D) 10%
Answer: A
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: accounts receivable
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) Which of the following terms would tend to minimize a firm's investment in accounts
receivable?
A) net 15
B) net 30
C) 1/15 net 45
D) 2/10 net 30
Answer: D
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: accounts receivable
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) Management of a firm's liquidity involves management of the firm's investment in current
assets.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff

35
Copyright 2011 Pearson Education, Inc.

9) When faced with a surplus of cash, most firms should stretch their trade accounts.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) T-bills and Treasury bonds are guaranteed by the full faith and credit of the United States and
are therefore default-free.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) A banker's acceptance is a draft drawn on a specific bank by an exporter in order to obtain
payment for goods that he has shipped to a customer who maintains an account with that specific
bank.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) A negotiable certificate of deposit (CD) is a marketable receipt for funds deposited in a bank.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Although CDs are slightly more risky than Treasury bills, the yield is usually slightly less.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) If revenues can be forecast to fall within a tight range of outcomes, then the ratio of cash and
near-cash to total assets will be greater for the firm than if the prospective cash inflows might be
expected to vary over a wide range.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright 2011 Pearson Education, Inc.

15) Electronic funds transfer (EFT) could eventually eliminate the use of most checks and
minimize float.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) Commercial paper is a short-term, unsecured promissory note.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) One of the attractive features of commercial paper is an active secondary market.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) Marketable securities are near-cash assets because they can be converted into cash quickly.
Answer: TRUE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Investing in additional marketable securities and inventories creates higher profitability and
lower liquidity.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: cash and marketable securities
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) The minimum level of inventory the firm plans to hold for the foreseeable future is a
temporary asset investment.
Answer: FALSE
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: inventories
Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.

21) Briefly describe at least three useful tools for maintaining control over accounts receivable.
Answer: Ratio analysis: by tracking the average collection period the firm knows whether
customers are taking longer to pay their bills.
Aging the accounts receivable allows the firm to determine what percentage of accounts are past
due, how long past due they are, and whether the situation is getting better or worse.
It is useful to track the ratio of bad debts to sales over time to determine whether the firm should
pursue stricter or more liberal credit policies.
Diff: 2
Topic: 18.5 Managing the Firm's Investment in Current Assets
Keywords: accounts receivable
Principles: Principle 2: There Is a Risk-Return Tradeoff

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Copyright 2011 Pearson Education, Inc.